China A-Shares: Perspectives From The Inside Out


2019/05/03 00:00
  • The domestic A-share market offers the biggest and most diverse universe for long-term growth opportunities in China.
  • 国内a股市场为中国提供了最大、最多样化的长期增长机会。
  • Despite its size and liquidity, the A-share market remains highly inefficient and idiosyncratic – providing plenty of opportunities for active investing.
  • 尽管a股市场规模庞大、流动性充足,但其效率仍然非常低,而且具有特殊性——为积极投资提供了大量机会。
  • Local knowledge and a systematic approach attuned to the distinct factors driving the A-share market provide opportunity for consistent alpha generation.
  • 本地知识和与推动a股市场的不同因素相适应的系统性方法,为持续产生阿尔法提供了机会。

China’s onshore equity market – the world’s second-largest in terms of market capitalization – has never been more accessible to international investors. However, finding a strategy suitable for a market whose dynamics and characteristics are decidedly different from those of most other markets in the world can be a challenge.


Here, we provide international investors with insights into navigating China’s market anomalies from an onshore perspective and present the case for a systematic approach to alpha generation.


Capturing China’s growth opportunities


In the 40 years since Chinese leader Deng Xiaoping launched unprecedented market-oriented reforms, China has metamorphosed into a global economic power faster than any other country in history. China has eclipsed several developed economies in many respects, from the symbolic (e.g., half of the world’s top 10 tallest buildings are in China) to the significant (e.g., it is the largest contributor to global GDP in purchasing power parity terms). And it is not about to stop here – we expect real GDP in China to grow at more than twice the pace of that in the US and run ahead of most economies in the world.


Over the years, China’s domestic equity market has grown to become the world’s second-largest in terms of market capitalization at US$6.8 trillion,1 with an average turnover of US$56 billion.2 Previously closed to foreign participation, the onshore market has opened to global investors in recent years, with many international portfolios today holding increasing, albeit still small, exposures to the local currency-denominated, domestically listed A-share companies through MSCI and other benchmarks.3


IMF 2019 Real GDP Forecast


China’s Expanding Much, Much Faster Than Developed Markets Are


How China’s Stock Exchanges Have Grown


China’s long-term prospects rest on its critical pivot from the industrial-led growth formula that steered the country to its current economic status in favor of “new economy” growth drivers like consumption and information technology. Policymakers view this generational shift as essential in sustaining Chinese growth and prosperity well into the future.


On the ground, we see technological innovation, evolving consumer trends, financial reforms, and trade reshaping Chinese business models.


‘New’ China’s Return on Equity Is Outpacing the Old


The “factory of the world” image of China is gradually giving way to a high-tech China, aided by increased spending in research and development that is expected to outstrip the US and eurozone economies in a few years. Although China is still behind in many areas, significant amounts of state and venture capital investments are pouring into key technological areas, such as virtual reality, autonomous vehicles, 3-D printing, robotics, drones, and artificial intelligence (AI). With China already regarded as the second-largest AI ecosystem in the world,4 the government aims to make it a global leader by 2030.


The rise of China’s middle class and millennial generation also portends a disruptive force that is likely to yield new investment opportunities. Total retail e-commerce sales in China have eclipsed those of the US since 2013, accounting for 56% of the value of global retail e-commerce transactions by the end of 2019.5 At the same time, China is deepening its global economic influence with the ambitious “One Belt, One Road” infrastructure and trade initiative, connecting 65% of the planet’s population6 across Asia, Europe, the Middle East, and Africa.


China’s R&D Spending Is Escalating


This new era of transformation creates fertile ground for active investors who can identify companies that capitalize on these trends, evolve their businesses to be forward-looking, and have strong management and sustainable business models. With over 3,500 listed companies, the A-share market is the largest investible universe in which to capture these opportunities.


Net inflows into A-shares have grown significantly since China introduced direct access to the onshore market through the Qualified Foreign Institutional Investor (QFII) in 2002 and the Renminbi Qualified Foreign Institutional Investor (RQFII) in 2011. These initiatives were followed by the game-changing Stock Connect program linking the Hong Kong Exchange with the Shanghai Stock Exchange in 2014 and Shenzhen Stock Exchange in 2016, which allowed foreign retail and institutional investors the ability to trade A-shares via Hong Kong intermediaries.

自2002年中国通过合格境外机构投资者(QFII)和2011年通过人民币合格境外机构投资者(RQFII)直接进入中国内地市场以来,流入a股的资金净流入大幅增长。随后,2014年香港交易所与上海证券交易所和2016年深圳证券交易所启动了“沪港通”(Stock Connect)计划,该计划改变了游戏规则,允许外国散户和机构投资者通过香港中介机构交易a股。

Net Inflows to A-Shares through Foreign Access Channels Are Rising


More Channels Are Open for Foreign Direct Access to China’s Onshore Equity Market


Why A-shares, and why now?


Before the opening up of the onshore market to foreign investors, direct investment into Chinese companies was done through overseas-listed share classes, such as H-shares, red chips, and P chips in Hong Kong and N-shares in the US.7 Among these share classes, H-shares had been the biggest in terms of market cap and offered the most diverse sector exposures. However, as China’s domestic economy flourished, the A-share market became more diverse and more liquid, and has surpassed H-shares in terms of market cap.

在岸市场开放之前,外国投资者对中国企业直接投资是通过海外上市股票类别,如h股,红色芯片,芯片和P在香港和N-shares US.7在这些股票类别中,h股一直最大的市值和提供最多样化的行业风险。然而,随着中国国内经济的蓬勃发展,a股市场变得更加多元化、流动性更强,市值已超过h股。

Breadth and dept


The A-share market is the largest and most diverse Chinese equity opportunity set.8 While H-shares are dominated by financial stocks, A-shares better represent the evolving Chinese economy with more balanced weights across traditional sectors such as financials, industrials, consumer goods, and basic materials, as well as “new” sectors such as IT and health care. The A-share market enjoys vibrant trading by Chinese retail investors, which make up more than 80% of total trading volume.9


A-Shares Better Represent China’s Evolving Economy


Increasing relevance


The landmark partial inclusion of A-shares in the MSCI Emerging Markets Index in 2018 instantly increased the exposure of portfolios linked to the benchmark. A-share exposure will continue to expand to as much as 3.3% by late 2019 from less than 1% today as more companies are added into the index,10 which could drive an estimated US$60 billion to $89 billion in foreign fund flows into China’s onshore stock market.11

2018年,a股在MSCI新兴市场指数(MSCI Emerging Markets Index)中具有里程碑意义的部分纳入,立即增加了与该基准挂钩的投资组合的风险敞口。随着越来越多的公司被纳入a股指数,到2019年底,a股敞口将继续扩大,从目前的不足1%增至3.3%。这将推动约600亿至890亿美元的外资流入中国内地股市

While index inclusion by MSCI and others has significant flow implications, A-shares remain an underrepresented opportunity. Even at full inclusion, A-shares are estimated to account for only 16% of the MSCI Emerging Market Index.12


Attractive valuations and returns


Aside from size and depth, the onshore market offers stronger and more persistent returns than major markets. Valuations remain attractive in terms of price to earnings growth – making Chinese equities a compelling addition to global portfolios.


Valuations Are Attractive


Average Cross-Sectional Dispersion Over 5 Years


A-Shares Provide a Wide Dispersion of Returns


Low correlations


A-shares also exhibit relatively lower correlations compared with other major equity markets, including EM, making them potentially effective diversifiers in a global portfolio.


A-Shares Have Relatively Low Correlation with Major Markets


Investing with Chinese characteristics


While A-shares offer compelling benefits, the market remains highly inefficient and idiosyncratic. International investors will find vastly different structural and behavioral paradigms at work in China than in most other markets.


Retail investor dominance


An enthusiastic army of retail investors is responsible for over 80% of total trading volume in A-shares.13 But what is a boon for liquidity can be a bane for market stability; retail investors rely on price momentum, speculation, and headlines rather than fundamentals when making investment decisions and their herd behavior can trigger sudden market movements. Trading activities by large Chinese state-owned institutional investors (the so-called “national team”) can also leave a major footprint on the market.


Trading restrictions


While trading suspensions are a common market-stabilization feature globally, they have been a cause of investor concern in China because of their frequency and duration. For example, on 9 July 2015 the Chinese stock market crashed and volatility reached 60%,14 with trading of over half of all China A-shares suspended at one point. Trading suspensions can be voluntary or mandatory and can take place for reasons such as company restructuring, change of ownership, or unusual price movements. However, since the peak in 2015, the number of suspensions has dramatically fallen by over 90% by February 2019.15 Even during the market selloff in the fourth quarter of 2018, suspensions continued their downward trend. Moreover, stricter rules were implemented in November 2018, which included fewer allowable reasons for suspension, greater disclosure, as well as reducing the maximum suspension duration from three months to not more than 25 trading days.16


State ownership of listed companies


State-owned enterprises (SOEs) play an outsize role in the Chinese equity market. In terms of capitalization, they dominate highly regulated sectors such as financial, energy, industrial, and utilities. Regulations and policies, therefore, have a significant influence on the business and financial prospects of these companies. A systematic approach that can isolate quality SOEs based on fundamentals or other metrics may offer greater flexibility for investors than market cap-based index investing.


Corporate governance and shareholder rights


Unlike the activist role institutional shareholders play in most developed markets, engagements with Chinese companies remain difficult and their outcomes limited. In a recent survey of China-listed companies, a majority of respondents see either a weak or no link between good corporate governance and good company performance.17


Since these anomalies have implications on returns, investors need to consider their investment approach carefully to effectively navigate this market.


Turning anomalies into alpha – systematically


Benchmark allocations tend to offer a shallow and undifferentiated approach to a market whose workings are decidedly different than most other markets in the world. And for the active investor, anomalies represent exploitable opportunities to generate alpha. In the A-share market, we believe a factor-based approach that targets specific stock attributes can offer an efficient and consistent way to sift through market noise and isolate the most compelling alpha opportunities.


Certain investment factors (attributes that are associated with higher returns) behave differently in the A-share market than in other markets, providing opportunity for investors to capitalize on factor-based principles.


Factors Perform Differently in China Than in the US and Hong Kong


Growing Stock Coverage by Private Data Providers


Onshore management offers the added benefit of decision making based on an intimate knowledge of China, access to uncommon data sets, and the ability to act timely on emerging opportunities and risks.


What to consider when choosing a quantitative manager


When considering an A-share active quant manager, investors may want to seek providers that have a live track record to ensure their model is sufficiently robust to deliver consistent alpha across a variety of market environments. For example, how a strategy performed during the 2015 crash and subsequent recovery period may provide clues to its upside/ downside capture ability. Investors should also consider how managers continually innovate their alpha model through market cycles.


Above all considerations, investors need to clearly define their investment objectives, risk/ return targets, time horizons, and the role that Chinese equities will play in their portfolios. A comprehensive analysis of the drivers of their portfolios can help avoid over or under diversification, and determine the optimal China equity exposure they need and the appropriate investment vehicle. A nuanced and well-thought-out strategy together with a reliable onshore partner should put the investor on solid footing for the opportunities ahead.


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